ECB lending guidelines turn one with little to celebrate

The first anniversary of the ECB's Leveraged Lending Guidelines is fast approaching, and a look at the data so far shows it has far from ignited some discipline into the market. Instead, the volume of highly leveraged deals continues to rise, while aggressive adjustments on financial metrics follow suit, according to Debtwire data.

"Banks are more worried about capital allocation, hitting budgets than the ECB guidelines. I don't think people even remember exactly what they are anymore," said a banker.

According to Debtwire Par, leverage in Europe saw an uptick in the share of deals levered north of 6x to 33% of deals from 30% in 2017. A look at each quarter shows total leverage ratio initially decreasing to 5.3x in Q4 2017 from 5.7x in Q3 2017 but continue to tick up to 5.6x in Q3 2018 to date.

Strong buyside demand has guaranteed very robust issuance this year, with the institutional loan pipeline reaching a peak of €28.2bn in May. It recently piped back up in September with €16.7bn worth of deals in the pipeline after slowing down during the summer holiday period.

And sponsors are taking advantage of the plentiful conditions to secure better terms, with equity cushions shrinking on average to 45% from 47% in 2017, with also a strong increase in deals with an equity portion below 40%.

That also extends to the definition of EBITDA, which allows for some creativity when calculating opening leverage, although the ECB is much stricter in its own definition.

"There are a number of ways to make it look like a transaction doesn't exceed 6x leverage," noted a CLO portfolio manager. "And let's not forget that the financial services sector is pretty inventive when it comes to ways of arbitraging legislation."

In H1 2018, the number of loan agreements with a cap on EBITDA add-backs plunged to 37% from 47% in 2017, while the use of builder baskets and freebies continuously increased in volume, according to XtractResearch.

Freebies featured in 87% of deals in H1 2018, up from 68% in 2017. Additionally, three quarters of this year's freebies were soft-capped to 100% of EBITDA, permitting a full turn of leverage above the maximum ratio. Also, 80% of deals permitted an equivalent amount of debt to be incurred outside the loan agreement.

Lastly, restricted payments and dividend distribution also became more aggressive. One recent example is Refinitiv, a $13.5bn-equivalent debt package deal featuring a 4.3x marketed secured net leverage and 5.3x total leverage based on $2.529bn pro-forma adjusted EBITDA, in which the covenant package showed a sweet-spot on guarantor coverage and various baskets worth $5.3bn. In particular, the deal included a debated provision that allows to use investment baskets as dividend baskets.

Turning a blind eye
Under the ECB's broad definition of leverage, total gross leverage includes undrawn revolving or capex facilities, as well as any additional debt permission included in the document, setting a 6x leverage threshold, as reported. So if this is strictly applied, most deals in the market would be in breach of the guidelines.

Market participants largely expect banks to tighten their grip on leverage once the ECB imposes penalties for non-compliance, as examined in the US.

"I think that the guidelines were well-meaning, but people won't comply until they have to. It is another example of how the European regulators are stuck behind how the market actually operates. I think the regulator will need some discussion and further thinking," said one lawyer.

In the US, once penalties were imposed, leverage started to decrease. But the portion of deals leveraged over 6x increased dramatically with the start of the Trump presidency, as reported. The guidelines had been treated as law since its introduction during the Obama administration. However, during the Trump administration a challenge was brought into the lower house of congress demanding the right to review and analyse it. As a result, the guideline is now essentially suspended for practical purposes.

The US guideline differs from the European one in a number of aspects. It encourages banks in limiting their exposure to deals leveraged over 6x, unless companies could prove their ability to repay all senior debt or half of total debt from free cash flow within five to seven years. And the cap on multiples applies only to the opening leverage.

Moreover, the ECB guideline allows banks to do deals with higher leverage on an exceptional basis requiring a higher level of reporting, as in the US, but it remains a guidance without any pass-or-fail test.

A shift towards less regulated shores
Even if the ECB manages to introduce penalties which result in a shift in behaviour from the banks, the ever growing private debt market is happy to wait in the wings and jump at the opportunity to take an even larger share of the market from the banks.

"In the past three years we saw a huge increase in private debt providers, which are unregulated and are willing to adopt very sponsor-friendly deals," said a second lawyer. "In particular at this stage of the economic cycle, a sponsor will pretty much always find someone prepared to lend at highly leveraged terms, whether or not the bank is prepared to do it, and banks have an exposure to these third parties. So, the whole financial stability regime that the ECB is trying to instill through this guideline is probably not effective."

"This raises some questions of financial stability. While it may reduce the over-leveraged assets on balance sheets of banks, from a pure financial stability point of view these banks are still in the market [via their exposure to third parties]," added the first lawyer.

This article was originally published in Unquote sister publication Debtwire

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